[3][4] Many businesses were unconcerned with, and did not manage, foreign exchange risk under the international Bretton Woods system.
It was not until the switch to floating exchange rates, following the collapse of the Bretton Woods system, that firms became exposed to an increased risk from exchange rate fluctuations and began trading an increasing volume of financial derivatives in an effort to hedge their exposure.
An example of an economic risk would be a shift in exchange rates that influences the demand for a good sold in a foreign country.
Another example of an economic risk is the possibility that macroeconomic conditions will influence an investment in a foreign country.
Other examples of potential economic risk are steep market downturns, unexpected cost overruns, and low demand for goods.
In international firms, economic risk heavily affects not only investors but also bondholders and shareholders, especially when dealing with the sale and purchase of foreign government bonds.
When investing in foreign bonds, investors can profit from the fluctuation of the foreign-exchange markets and interest rates in different countries.
Changing laws and regulations regarding sizes, types, timing, credit quality, and disclosures of bonds will immediately and directly affect investments in foreign countries.
For example, if a central bank in a foreign country raises interest rates or the legislature increases taxes, the return on investment will be significantly impacted.
One of the most effective strategies is to develop a set of positive and negative risks that associate with the standard economic metrics of an investment.
A firm has transaction risk whenever it has contractual cash flows (receivables and payables) whose values are subject to unanticipated changes in exchange rates due to a contract being denominated in a foreign currency.
When exchange rates appreciate or depreciate, significant, difficult-to-predict changes in the value of the foreign currency can occur.
Under the temporal method, specific assets and liabilities are translated at exchange rates consistent with the timing of the item's creation.
A deviation from one or more of the three international parity conditions generally needs to occur for there to be a significant exposure to foreign-exchange risk.
[16] Financial risk is most commonly measured in terms of the variance or standard deviation of a quantity such as percentage returns or rates of change.
Using the VaR model helps risk managers determine the amount that could be lost on an investment portfolio over a certain period of time with a given probability of changes in exchange rates.
Forward contracts are more flexible, to an extent, because they can be customized to specific transactions, whereas futures come in standard amounts and are based on certain commodities or assets, such as other currencies.
Because futures are only available for certain currencies and time periods, they cannot entirely mitigate risk, because there is always the chance that exchange rates will move in your favor.
[18] Two popular and inexpensive methods companies can use to minimize potential losses is hedging with options and forward contracts.
To enforce the netting, there will be a systematic-approach requirement, as well as a real-time look at exposure and a platform for initiating the process, which, along with the foreign cash flow uncertainty, can make the procedure seem more difficult.
[24] This requires an equal amount of exposed foreign currency assets and liabilities on the firm's consolidated balance sheet.
Firms may adopt strategies other than financial hedging for managing their economic or operating exposure, by carefully selecting production sites with a mind for lowering costs, using a policy of flexible sourcing in its supply chain management, diversifying its export market across a greater number of countries, or by implementing strong research and development activities and differentiating its products in pursuit of less foreign-exchange risk exposure.
[17] By putting more effort into researching alternative methods for production and development, it is possible that a firm may discover more ways to produce their outputs locally rather than relying on export sources that would expose them to the foreign exchange risk.